“How much capital should I have in my firm?” It’s a question I hear frequently from lawyers and business owners. It seems like a simple question, but the answer is rarely simple.
The level of capital you need depends on your practice, and how quickly you can convert your services or inventory into cash. A grocery store, for example, generates cash every day the doors are open — but a law firm might not get paid for 60 days or longer after delivering a service. So the capital requirements for these businesses will be considerably different.
You Can Do the Math
You can figure out a number that works best for your practice by analyzing your working capital ratio and doing a little bit of math.
The working capital ratio measures operating liquidity and a business’s ability to meet short-term (upcoming) obligations. Current assets are cash or assets that are expected to convert into cash (e.g., receivables) within a one-year period or normal business operating cycle. Current liabilities are the counterbalance due within the same time period.
Working Capital (Current) Ratio = Current Assets / Current Liabilities
A working capital ratio of less than one indicates negative working capital (more liabilities than assets), while a value of two or more could indicate excess assets, which also can be an issue.
One practical method to determine the right amount of working capital is to run your business through a simulated stress test. If business dropped by 25 percent and collections slowed, could you make it for six months or more with your current capital and financing? Consider the fact that many businesses that stumbled in late 2008 are just now stabilized and back on their feet.
If you determine that your business’s capital is too low, talk with your accountant. One strategy is to raise capital over time by leaving some extra in each year until you achieve the desired level.
When a downturn comes along, having capital in the business becomes vitally important. Asking shareholders or members to put money in the firm is a difficult conversation and, in many cases, people simply don’t have it. If the firm has retained adequate capital, you don’t have to ask — you already have their money.
It’s More Than a Numbers Game, Though
While financials are great tools to manage a business, they’re not the only consideration when it comes to cash and working capital.
Instead of relying solely on working capital, many professional services firms use a line of credit. The line is used to fund short-term gaps like receivables and work-in-process. Leverage is great as long as business is steady, and when it comes to a line of credit, bigger is better — as long as you are smart about using it.
Often businesses make the mistake of financing long-term assets this way. Instead, if you are buying vehicles or equipment, ask your banker about a term loan.
Also, most owners never consider the potential personal liability on a bank line of credit. Bank lines generally provide for joint and several liability, meaning the bank can come to all parties (owners) for the full amount owed. So, in a three-owner firm the bank could collect the full amount from any one shareholder, leaving him or her to collect from the others. As one banker told me, “When banks have to collect, they take the path of least resistance.”
Less borrowing and more equity means less risk for shareholders — especially for those owners who are financially stronger than others. If this is a concern, next renewal ask your banker if a reduced proportional guarantee is an option.
Too Much Capital? A Reason to Evaluate Alternatives
Some businesses simply have too much cash on hand. In these cases, business lawsuits are a risk. Regardless, the situation needs attention. We were finally able to convince one client who had accumulated excess cash to distribute funds to himself. If the business needs it, we told him, he could lend funds back. The same situation with a multi-owner law practice or business might call for a different solution. Keep that in mind when advising clients.
Again, there’s no simple answer to how much capital is enough for your practice. However, you can take steps now to determine the optimal balance within your firm.